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Wednesday, February 3, 2016

House Money Effect and Intra-Trade Drawdown

I have been (officially) trading the Range Compression Trading System since January 6.... but I have been trading the system even earlier. In November, I was mechanically trading this very same system, but with somewhat different rules. Even in the first few days of January, when I was not trading the Range Compression Trading System, I was still marking possible entries on the charts.

This system does have a major flaw, if I may call it that... at least psychologically, and even mathematically, I view it as a handicap. With the current mechanical Trailing Stop rules that I use for the Range Compression Trading System, it is given to huge intra-Trade Drawdowns.

I have written about this earlier, and my rough estimate for intra-Trade Drawdown in January was about 15% of the Nifty scrip value. What is the problem and why is it affecting me? If it is a problem, why am I not fixing it? If I am not gonna fix it, then why am I worrying about it?

If I had the answers to these questions, then I would have already fixed it (obviously... probably?). Right now, I can only think of one reason - House Money.

House Money Effect

House Money Effect is the tendency of people to spend/risk income and profits from unexpected or recent sources more easily than other money. Though this term is generally relates to gambling casinos, where gamblers are more inclined to risk gambling gains on bigger or riskier bets, it is also common to see the general public spend a new bonus/windfall money more easily - on treats for friends or gifts, because they still have to get used to the fact that it is their own money, or even because of social expectations.

In terms of trading, this results in the tendency of a trader to take bigger or riskier trades with profits. In my specific case, it even means giving up profits - and additionally booking a loss in its place. How crazy is that?

Data and Analysis

The data of all intraday trades that I have done using the Range Compression Trading System in 2016 indicates my proclivity to give away House Money. Here, I am referring to unbooked Profits - that which is not mine, but is mine at the same time. (The term is unbooked Profits, as opposed to notional profits, since I could easily book them at or near the peak.)

The average MFE (Most Favorable Excursion) per trade is about 31 points, and I generally book 9 points out of that. The peak intra-Trade Drawdown is -23 points per trade - which means that in every trade, I watch the trade lose 23 points and do nothing about it. Around 10% of the time, I watch it lose over 40 points, and 27% of the time I watch the trade lose over 30 points and do nothing about it. Again, let me stress that I am day trading, and 30 points is about 0.4% of the scrip value.

Psyching about House Money

When this happens, and I, as a day trader who does not know what tomorrow brings, watch myself giving up a large part of my unbooked Profits.... then there is a lot of psychological pressure to do things differently - to attempt to capture the Profits at or near the peak. However, as a Systematic Trader, I am constrained to do what my System Rules tell me. In case I did not mention it earlier, let me tell that this Trading System has not been backtested.... so the only thing that keeps me at it are the live results. And that becomes really difficult when I hit a bad losing streak like the one which I am in right now.

When on a winning streak, it is easy to justify the House Money Effect, since money comes in anyways. But when you are on a losing streak, giving up the House Money, and then giving up some more, things are different.

So, again, why do I have to stick to a non-backtested system, giving up significant amount of unbooked profits, day after day, and week after week? Because I don't know better. Because the results until the current losing streak were good. When I have tighter Stops, I tend to be shaken out of big moves. Also, waiting for the wide Stops to be hit also keeps in a trade longer, and hence prevents me from overtrading.

Ok, enough psyching about this. I have put forward my justifications to myself to treat intra-Trade Drawdown as House Money. Time to watch how the Trading System psyches me tomorrow....